THE ECONOMICS OF ODIOUS DEBT
DOERTE DOEMELAND
FREDERICO GIL SANDER
CARLOS ALBERTO PRIMO BRAGA*
December 2008
(Preliminary draft – Please do not cite)
Abstract
CSOs have proposed different policy approaches to protect the population from servicing “odious” debts, i.e. that
loans are made to sovereign borrowers that are not used in the interest of the population. This paper raises the
question whether the proposed policy approaches would actually achieve their objective. It asks whether the
proposed frameworks would indeed make it cheaper for borrowers to repudiate loans deemed odious, analyzing the
potential impacts of different frameworks on borrowing costs. The paper concludes that all “odious” debt policy
proposals entail significant costs for the borrowing country. Frameworks based on regime–type approaches pose
tremendous challenges for the body or bodies charged with adjudicating on the type of regime, and in addition
generate incentives for despots to default, especially to those creditors most committed to the goals of the
framework. Frameworks based on individual loans entail direct legal costs – whether of auditing loan portfolios and
litigating or certifying that each loan complies with the framework’s standards. Ex-ante frameworks appear superior
to ex-post ones as they minimize the impact on non-odious governments, although they do not remove all
uncertainty: many countries will be penalized for the probability of being declared odious even if they never turn out
to be, and worthwhile but risky projects may not be undertaken.
*This paper has been prepared for the conference “Debt Relief and Beyond: A World Bank Conference on Debt and
Development”. The paper benefited from invaluable comments by Maurizio Ragazzi and John Williamson. The
authors would also like to thank Emeka C. Osakwe for excellent research assistance. All views expressed in the
paper remain those of the authors and do not reflect either the views of those who have contributed comments or the
positions of the World Bank’s management, Board of Executive Directors or member states. Financial support from
the Norwegian Ministry of Foreign Affairs is gratefully acknowledged.
1
I.
INTRODUCTION
In recent years, some civil society organizations (CSOs) have stepped up their advocacy for the
cancellation of so-called “odious” debts, which may broadly be defined, for the purposes of this
paper, as loans to sovereign borrowers that are not used in the interest of the population. They
argue that “odious” debts should be cancelled on moral grounds and advocate the
implementation of a framework that would exempt the governments that repudiate odious debts
from any legal consequences. The aim of this paper is to contribute to a better understanding of
the economic implications of instituting such a framework. 1
All borrowing – whether by governments (“sovereign borrowing”) or private entities – is
characterized by at least two potential conflicts of interest (“agency relationships”): the first,
between creditors and borrowers, and the second between those responsible for contracting debt
and those who ultimately bear the burden of servicing it. 2 Ensuring the alignment of the interests
within each pair is a fundamental problem in contract theory. The nature of the problems is
similar for sovereign and private borrowing, but their solutions are fundamentally different.
The incentive problem between creditors and borrowers is straight-forward: having contracted
debt, the borrower would prefer not to repay it. The creditor only lends, however, if he has a
reasonable expectation to be repaid. To solve this problem, creditors of private entities can rely
on the judicial system to reassign the property rights of assets from the borrower to the creditor
should the borrower default. This not only reduces incentives for non-payment by borrowers, but
also provides incentives for creditors to enforce their claims since the prejudicial consequences
for a defaulting debtor provides them with a direct benefit. Both creditors and borrowers gain
from the enforcement mechanism since it allows trade of resources to take place.
For sovereign borrowing, the solution is less simple and there is great controversy as to the
practical reasons why countries comply with their contractual obligations and repay their debts.
1
A detailed discussion of the different definitions of odious debt and their reflection in law is provided in Nehru and
Thomas (2008).
2
Note that the creditor in the first relationship is the country, represented by the government. The creditor is
therefore not one actor (government, population) acting independently, but rather the outcome of the first agency
relationship: the government acting on behalf of the population.
2
As noted by several authors at least since Eaton and Gersovitz (1981), the transfer of property
rights from a sovereign borrower to its creditors through the courts poses substantial challenges.
Creditors would not be expected to obtain favorable judgments in courts of the borrowing
country, and judgments obtained in foreign courts are generally enforceable only in a subset of
jurisdictions and therefore be limited to assets located therein. While cross-border enforcement is
possible in principle (through “gunboats,” for example), most authors agree that this is politically
untenable today, and there is evidence that even well-known historical examples of “gunboat
enforcement” may overstate its role (see Tomz, 2007, chapter 6). Some authors have therefore
argued that sovereign borrowing needs to be self-enforcing (or enforced by the “market”)
through optimal reactions by creditors that would lead, for example, to the exclusion of
defaulting countries from future borrowing. A lack of coordination among creditors can,
however, easily undermine self-enforcement, making it more difficult for creditors to be repaid
once a sovereign creditor declares default 3
Solving the second incentive problem – between those responsible for negotiating and
contracting the loans and those that bear the burden of repayment – is even more complex in the
context of sovereign borrowing. The design and enforcement of anti-corruption and transparency
laws (analogous to the laws that protect shareholders from management fraud) are ultimately
done by the public authorities of the sovereign borrower, and not an independent party. Most
importantly, outcome-contingent compensation contracts for government leaders, such as those
that exist for managers of private firms, do generally not exist (for example, in no country does
the president earn a bonus for exceptional economic growth). 4 The main form of incentives
provided to government executives is the possibility that they may not be re-elected or may be
overthrown.
3
Bulow and Rogoff (1989) argue that non-creditor banks would profit from selling an insurance contract to the
defaulting country (using the defaulted amounts) that would remove the consumption-smoothing motive for
borrowing, thus rendering market exclusion an ineffective punishment. These authors conclude that, absent market
or political enforcement, only the existence of legal threats can ensure sovereign debt repayments.
4
The recently instituted $5 million prize to “well-behaved” African Presidents, funded by Sudanese telecoms
entrepreneur Mo Ibrahim, could be considered as a proxy for such a concept. For further details see Reuters
Foundation, “Thumbs up or down for African prize?” at www.alertnet.org/db/blogs/22870/2006/09/27-1339571.htm
3
Figure 1: Agency problems in sovereign debt
Government
b2 B
b1
Population
a2
A
a1
Creditor
Sovereign
Borrower
A: Agency relationship
between the creditor, who
provides credit (a1) and the
sovereign borrower, who
repays the loan (a2).
B: Agency relationship
between the population,
who pays taxes (b1) and
the government, who
provides public goods (b2).
This agency problem between government executives and their population is ultimately at the
heart of the debate over the cancellation of “odious” debts: definitions of “odious” debt proposed
in the literature tend to have in common that the proceeds from the borrowing were not used for
the benefit of the population of the country. 5 Proponents of the different policy approaches on
odious debt argue that placing the responsibility on lenders to ensure that loans to sovereign
borrowers are aligned with the interests of the population would solve this incentive problem,
The paper identifies four different policy approaches to odious debt. The odious regimes framework
argues that no debts incurred by a regime deemed odious should be enforceable. Under an ex-post version
of this framework, successor regimes can argue (through litigation) that the predecessor regime was
odious – and therefore that debt contracted by the predecessor need not be honored. In practical terms this
would imply that successful litigation would prevent courts from attaching assets to enforce the
repayment of a debt contracted by the odious regime. Under an ex-ante version of the odious regimes
framework, put forward by Jayachandran and Kremer (2006) and Bolton and Skeel (2007), an
international body (such as the United Nations Security Council) would declare certain regimes
5
The emergence of a doctrine of odious debts is generally linked to Alexander Nahum Sack (1927), who identified
three categories of odious debts, namely: (a) “regime debts” (when a despotic regime “contracts a debt, not for the
needs and in the interest of the state, but to strengthen its own despotic regime”); (b) “subjugation debts” (when the
government “contracts debts to subjugate the population of part of its territory or to colonize it by members of the
dominant nationality”); and (c) “war debts” (when the government of a state contracts debts “with a view to waging
war against another state”). However, the concept of odious debt as currently used by Civil Society organizations
has been expanded, including “criminal”, “ineffective” and “unfair” debts or debts “used against the interest of the
population.” Regarding the application of this expanded definition, there are formidable practical difficulties in
determining whether debts were contracted against the interest of the population, an issue that we do not discuss in
this chapter.
4
odious and agree that courts in member countries would not enforce debt contracts entered with such
odious regimes.
The odious loans framework argues that those loans that were used against the interest of the population
should be cancelled or declared unenforceable. Under the ex-post version of this framework, old loans are
audited, and those deemed illegitimate (regardless of the regime that contracted them) are repudiated.
This would provide incentives for creditors to “enter” the second agency relationship (the dashed
line in Figure 1) in order to reduce the risk of not being repaid. Under the ex-ante version of this
framework creditors must undertake sufficient due diligence to certify that a loan is being used for
legitimate purposes, in which case that loan could not later be deemed odious.
All proposals implicitly assume that the enforcement of sovereign borrowing takes place through
the legal system – and therefore that borrowers would indeed repudiate “odious debts” if they
were legally allowed to do so. 6 This assumes that repudiation backed legally by an odious debt
framework would result in few or no costs to the borrower. While this seems plausible at first
sight, the extent to which legal enforcement is effective in the context of sovereign debt is
unclear. Moreover, some authors argue that the costs of market enforcement dominate those of
legal enforcement. Putting the argument differently, a country could, without an odious debt
framework, repudiate its debts for any reason, including on the basis that they are deemed to be
odious. To be beneficial to a debtor country, and ultimately a country’s population, the proposed
policy approaches must reduce existing costs of repudiation.
Therefore, in this paper we draw from the literature on sovereign debt to ask two questions that
are fundamental in the “odious debt” debate: (1) what are the costs that countries would
experience if they were to repudiate debts deemed in any way ”odious”; and (2) how would the
implementation of the above mentioned odious debt policies change these costs?
Throughout this paper we recognize that there is an important distinction between commercial
creditors (including bondholders) and official creditors (both bilateral and multilateral).
6
This is largely reflected in the current debate over the existence of an “odious debt doctrine”. See, for example,
Thomas and Nehru (2008). The main exception is Kremer and Jayachandran (2002), who considered the effect of an
odious debt regime on market enforcement. Curiously, Jayachandran and Kremer (2006) return to legal costs as the
sole enforcement mechanism.
5
Commercial lenders are assumed to maximize profits, whereas official creditors are motivated by
non-commercial interests, such as political incentives, poverty reduction, etc., that would be
expected to lead to behaviors distinct from commercial creditors.
This paper is organized as follows: in Section II, we review the enforcement mechanisms
identified in the literature and the existing estimates of their relative importance; in Section III
we discuss how the different proposals for an odious debt doctrine in international law could
affect these costs; Section IV draws the conclusions.
6
II.
THE COSTS OF DEBT REPUDIATION
In this section we examine the costs that a country would face if its government decided to
repudiate its debts, a subject that has been studied extensively in the economics literature. As
discussed, in the previous section solving the incentive problem between creditors and borrowers
is not straightforward in the context of sovereign debt. We therefore first identify and discuss
broad types of enforcement mechanisms that have been proposed in the literature to ensure
payment on external debt by sovereign borrowers. In the second part of this section, we discuss
the empirical evidence on the magnitude and relevance of these different types of costs.
Table 1: Costs of debt repudiation
Enforcement
Official Creditors
Commercial Creditors
/Creditor Type
Political
Legal
Market (selfenforcing
mechanisms)
-
“Gunboats” (military intervention or pressure)
Trade sanctions
External control of a country’s finances
Restrictions on access to new
- Asset seizures
financing
- Cross default
- Comparability of treatment
- Legal barriers to access to finance
clauses
(e.g. trade credits).
- Reduced ability to lend in the
- Higher costs of financing
long-term (resource
- Limited access to new financing
constraints)
(e.g. trade credits)
- Capital flight
- Impact on domestic economy
Three broad categories of sanctions have been postulated in the theoretical literature as enforcing
sovereign debt contracts: political, legal and market enforcement, which are summarized in
Table 1. While it seems obvious that political enforcement (“gunboat diplomacy”) could, in
principle, enforce sovereign debts, there seems to be an equally strong consensus that this type of
enforcement is essentially untenable politically in present times. The relevance of legal and
market enforcement mechanisms is controversial in both the theoretical and empirical literature.
In general, authors recognize that some legal enforcement exists, though its role is generally
much less important than in the context of private borrowing. Most of the theoretical literature
7
that argues in favor of a prominent role for legal enforcement does so as a “residual” explanation
after arguing against market enforcement.
1. Types of Enforcement
Political enforcement refers to actions imposed by governments on creditor countries in
response to a default and includes military action (also commonly known as “enforcement by
gunboat”), trade or other diplomatic sanctions, as well as external control of the country’s
finances (e.g., customs revenues). 7 Political enforcement does not require a court ruling on the
default, and its main characteristic is the act of a sovereign government against another.
Legal enforcement refers to the costs that emerge as the result of legal proceedings, or from the
activation of contractual clauses. This category includes asset seizures, the activation of
contractual clauses (such as cross-default), as well as expenses incurred in the process of
litigation (lawyers’ fees, the time that government officials must spend assisting in the process,
etc.). It would also include consequences (such as difficulty in obtaining new financing) that
arguably would not be experienced absent litigation. 8 Delays to restructuring defaulted debt
caused by legal action or contractual obligations (e.g., unanimity clauses) may also be included
as legal costs if such delay is costly to the country (e.g., if it cannot borrow while it remains
formally in default). Contrary to political enforcement, legal enforcement does not necessarily
take place in the sovereign borrower’s jurisdiction. 9 Rather, legal proceedings usually take place
in the courts of the creditor countries, which implies that only those assets that are outside the
borrowing country are available for seizure and attachment by the courts, save for procedures for
the recognition of foreign judgments in the borrowing country.
Market enforcement refers to the impact of a default (or the risk of default) on the borrower’s
access to new financing. As a consequence of default, the cost of new loans may be higher, or
the amount of available financing may be lower. This mechanism is also frequently referred to as
7
Mitchener (2005) refers to political sanctions as “supersanctions.”
For example, creditors tried to stop Argentina from proceeding with its debt restructuring transaction by asking the
courts to seize the bonds tendered in the exchange as an Argentine asset.
9
However, exceptions exist: some Latin American railroads were seized by creditors in the late 19th century.
8
8
“reputation.” For our purposes, it is useful to think of it as the contract’s self enforcement
features that would emerge without any legal or political enforcement. The proposed odious debt
policies, while possibly influencing legal costs, are unlikely to affect the consequences ensuing
from the self-enforcing nature of sovereign debt contracts.
There are two main types of theoretical models that explain why a default leads to restrictions in
a country’s access to finance. In “adverse selection” models, there are different types of
government: “good payers” and “bad payers”. 10 A default provides a signal that the government
is of the “bad payer” type, which would imply higher financing costs. Under certain “moral
hazard” models, if countries are motivated to borrow to smooth consumption during bad times, a
possible equilibrium of the repeated borrowing game would be for creditors to exclude
defaulting countries from borrowing in the future to enforce payment (Eaton and Gersovitz,
1981). 11 A related model (Grossman and van Huyck, 1989) differentiates between “excusable”
defaults (when the country is unable to pay due to a negative shock) and non-excusable defaults
(when the country is able, but unwilling, to pay), with only the latter leading to exclusion from
the credit markets.
Higher interest rates and/or limitation on new financing are expected to have economy-wide
impacts. The reputation in sovereign debt repayments could affect other economic areas, such as
trade or FDI, therefore generating an economy-wide negative impact of default (see, for
example, Kletzer and Wright, 2002). Moreover, some reputational models suggest that a default
signals a bad “type” not only with regard to sovereign debt, but also to property rights in general,
which may lead to capital flight. The government’s inability to borrow externally combined with
capital flight would exert pressure on the domestic economy through effects on the exchange rate
10
“Adverse selection” models were introduced by Akerlof (1970), who noted that relevant characteristics of actors
are often observed only imperfectly (in this example, the willingness to repay of governments), and creditors must
rely on estimates. When types are indistinguishable, the average willingness to pay is below that of “good payers”,
but above that of “bad payers”. Since borrowing costs can only rely on the average, costs are too high for “good
payers,” who may choose not to borrow, and too low for “bad payers.” Therefore, there will be an (adverse) selfselection of “bad payers” in the market. This situation can be partly remedied by credible signals of
creditworthiness.
11
“Moral hazard” models imply that the actions of actors are imperfectly observed, and would emerge, for example,
when it is not possible to distinguish whether a default is a result of inability or unwillingness to repay. Because of
this, there is a “temptation” by borrowers to claim inability when they are actually unwilling to repay.
9
and the domestic public debt. Finally, domestic financial institutions may be holders of the
government debt, which could create a link between domestic banking crisis and a default on
sovereign obligations.
2.
Enforcement by Type of Creditor
While market enforcement applies primarily to commercial creditors, official creditors mimic
some enforcement mechanisms of the market by reducing (or suspending) lending to borrowers
who default to them. While a political decision could be made to remove these sanctions, we
consider them a form of legal enforcement mechanisms since they are generally anchored in the
creditors’ statutes. For example, default to multilateral creditors generally triggers a contractual
suspension of new disbursements.
Official creditors have also used litigation in the past, but mostly indirectly through the sale of
claims to private creditors that then attempt to enforce them through the legal system. 12 Another
example of contractual enforcement used by official creditors is the comparability of treatment
clause found in all Paris Club debt restructuring agreements. This clause requires borrowers to
seek comparable debt reduction from other bilateral creditors and also from commercial
creditors. It thus serves a similar purpose as a cross-default clause in some debt contracts by
preventing countries from “seeking debt reduction” on their official debt without “defaulting” to
commercial creditors as well.
Finally, the overall amount of resources available to official creditors – although ultimately a
political decision – is affected by default or the risk thereof. This is the closest to “market
enforcement” as it applies to official creditors, since it is driven by resource constraints. Lost
12
One example is the case Donegal versus Zambia. In 1979, Romania extended a US$15 million credit facility to
Zambia for purchasing agricultural machinery. Zambia defaulted and fell into arrears in 1981. In 1999, Donegal
International (a distressed debt fund) offered to buy the debt and after lengthy negotiation Romania sold the debt to
Donegal for US$3.2 million (on a claim with a face value of US$30 million). In 2007, the English High Court ruled
that Donegal could claim US$15.4 million. More information on this case can be found in Box 5 of “International
Development Association and International Monetary Fund, The Heavily Indebted Poor Countries (HIPC) Initiative
and Multilateral Debt Relief Initiative (MDRI) - Status of Implementation Report, August 2008” at
http://siteresources.worldbank.org/INTDEBTDEPT/ProgressReports/21501008/HIPCProgressReport20070828.pdf
10
flows from non-payment directly reduce official creditors’ resources for new lending. Moreover,
high risk of default requires greater provisions by some creditors, which reduces the amounts
available for new lending.
2. Empirical Evidence
2.1 Political Enforcement
There exists sizeable empirical evidence from economic history regarding past relevance of
political enforcement, such as military intervention or foreign control of a country’s economy 13
. Ahmed, Alfaro and Maurer (2007) show that the imposition of the “Roosevelt Corollary” –
whereby, in the first quarter of last century, the United States would intervene in Latin American
countries that had difficulties servicing their debts – reduced financing costs of the countries that
were intervened. Mitchener (2005) estimates a probability of political enforcement in case of
default in the period 1870-1913 (the gold standard era) of 25 percent. He finds that yield spreads
declined by about 800 basis points and the defaulting country experienced an almost 100 percent
reduction of the time in default when sovereign default was punished with political sanctions.
The relationship between default and political sanctions may, however, have been spurious as
Tomz (2007) points out. He notes that, prior to World War I, countries that defaulted were
indeed targets of military intervention at a higher rate than countries that serviced their debts. But
he argues that the political sanctions were more likely for defaulters since they were often
already involved in other disputes. As an example, he argues that the military intervention in
Venezuela in 1902 – one of the most prominent examples of “gunboat” enforcement – was not
due to the default on its foreign bonds, but rather due to other acts against British and German
interests. Specifically, although the Venezuelan government defaulted in 1901 on bonds held by
British and German investors, Venezuela had been in default four times between 1847 and 1901,
without any intervention by the British military. Tomz argues, based on an analysis of historical
13
An example is the case of the Egyptian default at the end of the 19th century. A costly war with Ethiopia and
lavish government spending led Egypt’s debt to climb fourteen-fold over a thirteen-year period and in 1876 the
country was essentially “bankrupt.” Ismail, the Khedive of Egypt, declared a unilateral partial default on the
outstanding bonds. In response, the British and the French governments demanded to intervene in the country’s
finances, and pressured the Ottoman Sultan to depose Ismail and replace him with his son, Tewfik. Egypt ended up
losing its national sovereignty. British and French officials took control of government revenue, managing it in the
interests of the private creditors. For further details see Chowdhry (1991)..
11
documents, that the real motivation for the intervention in 1902 was multiple attacks by the
Venezuelan navy on British vessels in the Caribbean.
Notwithstanding strong evidence that trade volumes are lower following default (see discussion
below), there is little evidence that government-imposed, overt trade sanctions have been used to
enforce sovereign debt contracts – at least in the past 30 years. Martinez and Sandleris (2006)
report that they could not find a single instance of substantial and overt trade sanctions in 116
sovereign defaults with private creditors and 269 with official creditors over the past 30 years.
Regardless of whether political enforcement was ever effective, it is incompatible with existing
international law, and there does seem to be a consensus against the utilization of such types of
intervention.
2.2 Legal Enforcement
An extensive literature has analyzed the legal mechanisms available to creditors and debtors in
the context of sovereign debt. 14 A key principle discussed in this literature is that of sovereign
immunity, even though such laws as the US’s Foreign Sovereign Immunities Act of 1976 or the
UK’s State Immunity Act of 1978 have stripped sovereign immunity related to commercial
transactions. Following a bellwether US Supreme Court decision in Republic of Argentina et al.
v. Weltover, which upheld that sovereign debt constituted a non-protected activity under the US
Sovereign Immunities Act, a number of other lawsuits have been brought forward against
defaulting sovereign borrowers with a mixed record of success. As noted by Sturzenegger and
Zettelmeyer (2007), both creditors and borrowers have honed their legal tactics, the former to
expand their abilities to seize assets, and the latter to avoid seizures.
A related literature on sovereign bankruptcy has analyzed the optimality of existing contractual
characteristics of sovereign debt and the need for a sovereign debt restructuring mechanism. 15
14
15
See, for example, Waibel (2003) and Sturzenegger and Zettelmeyer (2007).
See, for example, Rogoff and Zettelmeyer (2002) and Bolton and Jeanne (2007).
12
This literature focuses in particular on the tension between the ex-post and ex-ante efficiency of
certain aspects of sovereign bond contracts. Clauses that make debt restructuring difficult (for
example, those that require the unanimity of holders to modify the repayment terms of the
contract) make default more costly and therefore, ex-ante, reduce the risk premium that
borrowers must pay. However, once a default occurs, such clauses are inefficient. Ex-post, both
the defaulting borrower and a majority of creditors would prefer that restructuring were easier
due to the dead-weight losses associated with a protracted restructuring. This literature is mostly
theoretical, however, simply acknowledging that delays in reaching an agreement were costly in
a broad sense, usually measured in the aggregate using changes to GDP.
Empirical evidence on the average or aggregate importance of legal costs in enforcing sovereign
debt contracts, as well as estimates of their magnitude, has been limited. Evidence exists from
case studies, however, that the ability of creditors to ultimately obtain payments or asset transfers
from sovereign borrowers – what may be called “direct legal sanctions” – appears to have been
limited. Creditors have been able to obtain judgments in a number of cases, but have found it
difficult to collect on them (see Box 1 below for one example). This difficulty is reflected in the
fact that only a minority of creditors (so-called “distressed asset” funds) is usually involved in
lawsuits. Consider for example the recent default by Argentina in 2001. Despite unusually harsh
terms for creditors (namely a reduction in the present value of the obligations in the order of 70
percent), over 75 percent of creditors accepted the restructuring offered by the government in
2005 instead of engaging in lawsuits. This reflects the expectation by most investors that the
potential for recovery through legal means was limited.
Estimates of actual litigation costs, those expenses that governments must incur on lawyers’ and
court fees, as well as the opportunity cost of government officials that work on the litigation are
rarely discussed in the literature. Although those costs may be trivial in most cases (especially
relative to the costs of asset seizure), they can be significant for small economies and large
relative to the original claim amount, as shown in Box 1.
13
Box 1: Noga vs. Russia (updated from M. Wright, 2002)
Noga, a Swiss company, entered into a contract with Russia to exchange oil for certain products that it
agreed to export. Russia explicitly waived its right to sovereign immunity under the contract. In 1993,
Russia repudiated the contract and offered to settle it under London Club terms (i.e., with a discount on
the amount of claims outstanding). Noga sued, and obtained judgments in Luxembourg and Switzerland
to freeze Russian government bank accounts with US$700 million, which led Russia to establish a shell
company to hold its offshore assets. In 1996, the Luxembourg accounts were unfrozen, without a payment
being made to Noga. In 1997, a Swedish arbitration court awarded Noga US$63 million, compared to
US$ 800 million sought. Russia refused to pay and the lawsuits continued.
The year 2000 saw a number of lawsuits in different jurisdictions. A French court ordered the seizure of
bank accounts of some 70 Russian entities that were connected with the state, including the Russian
embassy in Paris and its UNESCO delegation. Within a few months of the award, a judge dismissed the
case and ordered Noga to pay damages to Russia. A French presidential decree was required to prevent
the seizure of Russian President Vladimir Putin’s personal aircraft at Orly airport, and Noga obtained a
judgment to impound a Russian ship in the French port of Brest, but again the suit was later dismissed
and Noga was ordered to pay damages. Noga also lost a suit filed in the United States requesting the
seizure of uranium that was allegedly owned by Russia.
In June, 2001, Noga attempted to seize Russian fighter jets at Le Bourget air show. The planes were
scrambled ahead of the bailiffs, after the Russian contingent were warned by the festival organizers, who
also helped drag the planes to the end of the runaway, gave permission for an emergency takeoff and
opened an air corridor.
The case continued in Swiss courts, which ruled again in favor of Noga in 2002. In 2005, 54 paintings
from the Pushkin Museum of Fine Arts, insured at a value of US$ 1 billion, were seized on their way
back from Switzerland to Russia. The Swiss government intervened, and the paintings returned to Russia.
In 2006, a Russian-born US investor appears to have bought the debt from Noga, although it is not yet
clear whether Noga no longer has any claims against the Russian government.
By March 2006, Noga stated it had spent US$ 40 million in legal expenses over the years, and it
estimated that Russia spent twice as much. As of May 2008, the Russian government had plans to sue
Noga for damages under previous seizure orders.
14
Recognizing that recent cases of sovereign default were very costly for both debtor countries and
creditors, the IMF proposed in 2001 the creation of a sovereign debt restructuring mechanism
(SDRM) to deal with unsustainable debt burdens of emerging market countries. The proposal
consisted, in particular, of establishing a universal legal framework to facilitate negotiations and
to empower creditors to approve a debt restructuring agreement with a debtor country that would
bind in minority dissenting creditors. The agreement could precede or follow an event or default.
At the same time, the IMF also considered a complementary approach, in which debt
restructurings could be facilitated by enhanced use of certain contractual provisions in sovereign
debt contracts. 16
Even if expected direct legal costs of defaulting may be limited, there is evidence that the threat
of litigation alone acts to restrict, at least in the short term, the access of countries to certain types
of financing. This applies particularly to trade financing, which relies on short-term credits and
letters of credit. Alexander (1987) notes that countries find it difficult to obtain letters of credit
during default – since creditors may fear that repayments on these new credit lines could be
seized, even if temporarily, by litigating creditors. This fear forces countries to conduct
roundabout transactions, which Alexander claims in one case to have been estimated at between
10 and 15 percent the value of trade. Similarly, it is possible that all types of borrowing are
restricted by the risk of seizures. Consistent with this hypothesis, there are very few exceptions
of countries that issue new debt before reaching a restructuring agreement with their creditors.
Tomz (2007) reports that, between 1820 and 1870, only a single loan was issued by a country
that was in default and had not yet restructured its obligations.
The line between these (indirect) legal costs and market enforcement (discussed below) is rather
blurry: it is possible that creditors would re-establish credit more quickly absent legal threats,
whereas they could also find alternative coordination devices to punish defaulting countries even
absent the threat of litigation. While we are not aware of a study that attempts to separate these
two channels, Ahmed, Alfaro and Maurer (2007) provide some insight by testing empirically the
comparative effectiveness of political and legal enforcement. Ahmed et al. compare the behavior
of borrowing costs following two important events: (i) the announcement of the “Roosevelt
16
More information on the SDRM can be found at http://www.imf.org/external/np/exr/facts/sdrm.htm
15
Corollary,” considered by most authors to be a period where political sanctions were widely used
to enforce sovereign debt, and (ii) the landmark 1996 decision of Pravin v. Peru, which signaled
to investors that courts could be used to force payments from creditors. The authors find
evidence that political enforcement (given by the Roosevelt Corollary) reduced borrowing costs,
whereas the impact of legal sanctions was “weak at best” (Ahmed et al. 2007, p. 26).
Nevertheless, because the data used to test the legal enforcement hypothesis begins after what is
probably a more important landmark from the point of view of investor expectations – namely
the above-mentioned 1992 US Supreme Court decision on Republic of Argentina et al. v.
Weltover – their conclusions must be taken with caution.
The literature is silent on actual estimates of the costs arising from legal enforcement by official
creditors. Nevertheless, the recent case of the Argentina default is illustrative. Argentina
defaulted on its Paris Club debt in 2002. Since then, many of the government-controlled
insurance agencies, export-import banks and other institutions linked to Paris Club members
have been prevented from extending insurance or loan guarantees for projects in Argentina due
to its default to the Paris Club. In the absence of such guarantees or insurance, many investors
shy away from riskier projects. For example, in 2007, the first $1.1 billion phase of a $3.3 billion
infrastructure project to extend passenger rail service in the greater Buenos Aires met with little
interest from investors. As the economic recovery was tempered by capacity constraints, the cost
of these sanctions has become more relevant, and Argentina in September 2008 indicated that it
planned to use US$6.7 billion of its international reserves to clear its arrears to the Paris Club,
thus re-opening short-term trade credits and insurance and guarantees for investment projects
financed by companies from Paris Club member countries. However, as the 2008 global
financial crisis brought liquidity constraints to the fore, the plan was postponed.
This case study is suggestive of the mechanism that may lie behind the results of Rose (2005).
Rose considers defaults to official creditors and finds that bilateral trade (between creditor and
borrower) declines by 8 percent per year following a default and last 15 years. Rose and Spiegel
(2002) use instrumental variables techniques and find a significant positive effect of bilateral
trade on bilateral lending patterns: an increase of 1 percent in bilateral trade increases bilateral
lending by 0.40 percent. These results must be taken with some caution, however, as defaults to
16
official and commercial creditors are correlated. Moreover, as discussed below, some authors
question whether there is a fall in bilateral trade or just a fall in overall trade, which may be
correlated with the cause of the default (a negative shock) and simply persist beyond the default.
Despite the relative shortage of empirical evidence on the costs of legal enforcement, it is likely
that they are not trivial, especially indirect costs related to the effect of legal threats on a
country’s ability to enter into short-term credit agreements and the statutory suspension of credit
from official credit agencies that provide trade credit, insurance and guarantees. Direct legal
costs have been important in specific cases – consider for example the case of Elliot Associates
v. Banco de la Nacion, where Peru was forced to settle with Elliot to avoid defaulting on all
creditors of its “Brady” bonds for purely legal reasons. The available evidence for the overall
impact of this (and similar) cases, however, appears very weak, as reported by Ahmed et al.
(2007) and supported by the small fraction of creditors that rejected Argentina’s restructuring
offer.
2.3 Market (self-) Enforcement
The economics literature has investigated extensively the empirical relevance of market
enforcement of sovereign debt contracts. The type of self-enforcing sanction most commonly
predicted by the theoretical literature – higher borrowing costs and/or difficulty in accessing
credit – has been directly studied by a number of authors. They find some evidence that
defaulting countries face, in the short term, higher financing costs and difficulty in accessing
credit; however, beyond a relatively short period following the resolution of the default the
effects are muted at best. A different strand of the literature looks at the effects of sovereign
defaults on the aggregate economy, which is likely to be influenced (if not caused) by the market
reaction to the default. These aggregate effects include impacts on GDP and trade. While
defaults are clearly correlated with drops in GDP and trade, the causation mechanisms are
unclear.
The literature overall has found a positive but small impact of default on the long-term cost of
borrowing. Lindert and Morton (1987) find that defaults in the nineteenth century and the 1930s
17
did not imply higher borrowing costs in the 1970s – thus long-term effects appear negligible. De
Paoli, Hoggarth and Saporta (2006) find that, for a given debt-to-GDP ratio, past defaulters pay
generally higher interest rates. For example, the three non-defaulters in their sample faced lower
spreads in the 2003-2005 period than ten out of the 12 defaulters – despite the fact that in most
cases the defaulters had lower debt burdens in the same period. Flandreau and Zummer (2004)
find that in the 1880-1914 period interest rates jump by 500 basis points immediately following a
default, then by 90 basis points in the year following the end of the default episode, and 45 basis
points 10 years after the default. Özler (1993) considers the impact of defaults between 1820 and
1930 and in the post-World War II period on loans extended over the 1968-1981 period. He finds
that defaults prior to the 1930s do not have any impact on credit terms. The impact of a default in
the 1930s is estimated at 20 basis points, while the impact of post-war IMF stand-by
arrangements is estimated at 30 basis points. Borensztein and Panizza (2006a) also find that the
effect of default on spreads is short-lived.
The evidence on access to new financing is similar: defaulting countries eventually recover
market access, but they have problems accessing the markets before the default is resolved and
immediately after the default. As mentioned earlier, Tomz (2007) finds that only one country
issued debt between 1820 and 1870 while it was still in default. Eichengreen (1987) finds no
relationship between default in the 1930s and borrowing after 1945. Gelos, Sahay and Sandleris
(2004) find that the median number of years that countries are excluded from the markets
following a default fell from four in the 1980s to zero in the 1990s. The IADB (2007) notes that,
from the 1930s to the 1960s, all Latin American countries were largely excluded from the world
capital markets regardless of whether they had defaulted in the 1930s; on the other hand, the
lending boom of the 1990s did not exclude countries that defaulted in the 1980s.
An interesting paper by English (1996) on the external borrowings of US states in the early
1840s corroborates the evidence that market enforcement plays a role. The foreign debt of US
states prior to the Civil War was not guaranteed by a federal government. Given the status of the
US states, neither political nor legal enforcement was possible at that time. In the period of the
early 1840s, most US states never defaulted, some were temporarily in default or partially
repudiated their debts, and yet others repudiated their debts entirely. All states that did not
18
default were able to borrow again in the 1840s and 1850s, and all but 3 had more debt in 1860
than in 1841. The states that repudiated all their debt (Florida and Mississippi) did not issue new
bonds. The situation of those states that partially defaulted was somewhere in between, and
yields on their bonds remained elevated for several years.
Of course, costs of market enforcement may be different for different types of government.
According to Tomz, creditors assess a country’s “type” based on (i) whether the same type of
government is still in power; and (ii) whether that government has defaulted or repaid at a time
when the opposite would be expected (e.g., a repayment during a recession or a default during a
boom). Tomz (1998) notes that most defaults during the trough of the great depression were fully
expected, and therefore could not have affected the reputation of the borrowers. This would
explain why the effects on later borrowing costs were muted. On the other hand, the markets
rewarded countries that were expected to default but didn’t: in the 1930s, prices on Argentine
bonds reflected a 50 – 70 percent probability of default. As a consequence of not defaulting in
difficult times, Argentina was one of the only countries that issued debt in New York and
London during the depression. Özler (1993) notes that countries that had recently acquired
sovereignty in the 1960s and 1970s faced borrowing costs that were as high as those countries
that defaulted in earlier decades (i.e. they had not yet formed a reputation), whereas English
(1996) writes that the US states that had repudiated their debt in the early 1840s were only able
to borrow again after Northern-backed governments were installed. 17
A default is often associated with a decline in trade. One possible channel, discussed in the
previous section, is the shortage of short-term trade credits. The decline in trade would thus be
the consequence of default. Another possibility would be that trade falls in line with the overall
economy, and is thus related to the cause rather than the consequence of a default. The papers by
Rose (2005) and Rose and Spiegel (2002) discussed above support the hypothesis that –
regardless of the cause – trade declines follow rather than cause defaults. Similarly, Borenztein
and Panizza (2006b) find that, for each year in which the sovereign is in default, an industry in
the 75th percentile of the non-exporter/exporter continuum would see its growth drop by 1.7
percentage points relative to the 25th percentile. This effect only lasts as long as the country is in
17
See also Chapter 3 of Tomz (2007).
19
default, and only holds when considering defaults on bank loans (but not bonds). Alexander
(1987) and Cline (1987) provide anecdotal evidence that Bolivia and Peru suffered severe
reduction in their access to short-term trade credits as a consequence of their “confrontational”
approach. On the other hand, Martinez and Sandleris (2006) argue that the declines observed by
Rose (2005) are actually declines in overall trade – once this trend is taken into account, no
significant effect on bilateral trade is found. Similarly, Tomz (2007) argues that between the two
world wars governments did not service their debts in proportion to their trade with creditors,
which would be expected if the reduction in trade were a result of default.
Many authors have attempted to measure the overall correlation between GDP growth and
sovereign default. A commonly-cited estimate puts default “costs” at 2 percent of GDP growth
(Sturzenegger, 2002). 18 De Paoli, Hoggarth and Saporta (2006) report much higher output losses
– in the order of 7 percent per year for their median country. These measures are not very
informative for our purposes, since the mechanisms through which GDP growth falls are even
less well-specified than those in the case of trade. Moreover, there is substantial evidence that
countries default in bad times, when their GDP growth is trending downward, thus making it
difficult to distinguish between a sanction in anticipation of default and the cause of the default
itself. Tomz and Mitchener (2006) find that output is 1.4 percent below trend during periods of
default compared to 0.2 percent above trend when the borrower is in good standing, while LevyYeyati and Panizza (2006) find that, when the frequency of the data is changed from yearly to
quarterly, growth rates in the post-default period are never significantly lower than in normal
times. On the other hand, recessions are a significant 3 percent deeper during default episodes.
Some authors (De Paoli, Hoggarth and Saporta 2006) relate the growth costs to the fact that
sovereign defaults are connected to currency and banking crisis. 19 Often the domestic financial
sector holds government debt (including external debt, as was the case in Argentina), or its own
financing would be affected through the sovereign “ceiling,” namely the risk that governments
may impose restrictions on the exit of foreign exchange during an episode of default. However, it
is very difficult to disentangle whether a banking and/or currency crisis are contemporary to a
18
19
The cost is measured as the difference between observed GDP growth and trend GDP growth.
See Laeven and Valencia (2008) for an updated survey of episodes of banking, currency and sovereign debt crises.
20
debt default or whether they follow one. Given the evidence that countries generally default in
bad times, it is best to consider the “output costs” of default with appropriate caution.
The discussion on market enforcement focuses exclusively on commercial creditors.
Nevertheless, debt write-offs do impact resource constraints of official creditors. For example,
the expected debt relief to be provided under the Highly Indebted Poor Country (HIPC) Initiative
and the Multilateral Debt Relief Initiative (MDRI) as of 2008 by bilateral and multilateral
creditors is estimated at US$95 billion in NPV terms. 20
Therefore, there is evidence that defaults affect a country’s ability, especially in the short-term,
to obtain credit, which impacts trade patterns of the defaulting country. The impact of these costs
appears to be short-lived but, given the severity of the recessions that lead to default (or,
alternatively, the effort that some countries appear to exert to avoid default), they must be
sufficiently large. The degree of pain of the default serves as a signal that the default was a
matter of ability rather than willingness to pay, thus, if one accepts Tomz’s reputational theory,
not affecting the ability of the country to re-gain access to markets.
2.4 Summary of Costs of Repudiation
Although political sanctions are unlikely to be imposed nowadays should a sovereign
government repudiate its debts, there appears to be sufficient evidence that legal and market
costs, especially through their effect on trade, may be large. While there is limited evidence for
the relevance of direct legal costs or permanent increases in the cost of financing, credit
constraints seem to emerge in the short-term as a consequence of market enforcement, the threat
of litigation, and statutory constraints by official agencies.
As we noted in our discussion, it is difficult to separate the short-term impact on access to
finance that emerges from legal or market enforcement – indeed, it is very plausible that the legal
system acts as a coordination device for creditors. While legal costs cannot be ignored, the
balance of the evidence does not favor the view that they dominate. Consider that several studies
20
See International Development Association and International Monetary Fund (2008).
21
(Özler 1993, Rose 2005) find effects that last well beyond the immediate aftermath of the
default, thus well beyond the length of legal proceedings or suspensions due to default. English
(1996) plausibly argues that lenders to US states in the 1840s imposed market access restriction
without any apparent ability to obtain legal enforcement. The evidence in Alfaro et al. (2006),
while not decisive, also suggests that legal enforcement alone is not comparable to political
sanctions – begging the question of what has taken the place of the latter since it is no longer
available. Finally, the small number of creditors pursuing legal remedies in a given default, and
the many commercial banks that chose to delay declaring a default (and utilizing the legal
system) in the 1980s also points to an important, if not dominant, role for market rather than
legal enforcement.
Notwithstanding the empirical difficulty in separating legal and economic sanctions, in the next
part of our analysis, we continue to impose the abstract separation between legal and market
costs. It is only the latter costs that can be expected to be reduced by the proposed “odious debt”
policies, as recognized by Jayachandran and Kremer (2002).
Although the existing literature does not provide estimates of magnitude of the legal and
“market” costs imposed by official creditors, the practical implications of default to those
creditors are more clear-cut. Countries in default to the Paris Club are unable to access official
export credits and related agencies from other Paris Club creditors, unless a restructuring
agreement is reached. Moreover, default to multilateral creditors triggers a contractual
suspension of new disbursements from those creditors. The impact of defaults on the ability of
official creditors to provide development finance has not been studied in detail but, as discussed
above, in the absence of compensating transfers from donors, a higher number of defaults would
limit the long-term ability of official creditors to maintain their lending levels.
22
III.
POTENTIAL IMPACT OF IMPLEMENTING ODIOUS DEBT POLICY PROPOSALS
In the previous section we argued that the costs to a country that decides to repudiate its debt are
only partly determined by the legal actions available to creditors. In the case of debts to
commercial creditors, some (and likely most) of the costs that would emerge in case of such a
repudiation would arise from market enforcement. In the case of debts to official creditors, most
of the costs are indeed likely to be linked to legal action – although not in the sense of
international commercial law, where the odious debt policy proposals have been largely
explored, but rather as a result of the application of the statutes of these official creditors.
In this section we consider the impact of the implementation of different “odious debt” policy
proposals on the costs identified in Section II above. We divide these proposals into proposals
concerned with all borrowing done by specific regimes, which we term “odious regimes”
framework (Bolton and Skeel, 2007) and those that are concerned with the legitimacy of specific
loans: “odious loans” framework. For each of the two types we consider separately the impact of
an ex-ante and an ex-post version of the proposal, and on official and commercial creditors. In all
cases, we ask how the proposed policy would alter the costs of repudiating “odious” loans
compared to the existing costs of repudiation.
Under an “odious regimes” framework (see Table 2), all the debts contracted by a regime
deemed odious should not be enforceable. Under an ex-post version of this framework, successor
regimes can argue (through litigation) that the predecessor regime was odious – and therefore
that debt contracted by them need not be honored. In practical terms this would imply that
successful litigation would prevent creditors from attaching assets to enforce the repudiation of a
debt contracted by the odious regime. Under an ex-ante version of the odious regimes framework
an international body would declare certain regimes odious and invite national courts not to
enforce debt contracts entered with such odious regimes (or, as a variant, the UN Security
Council, acting under its peace and security powers, would adopt legally binding decisions to
that effect).
23
Under an “odious loans” framework, those loans that were used against the interest of the
population should be cancelled or declared unenforceable. Under the ex-post version of this
framework, previously contracted loans are audited and those deemed “odious” are challenged in
the courts, which may not enforce obligations it finds illegitimate. Under the ex-ante version of
this framework (which is more closely related to “responsible lending” rather than the different
odious debt policy proposals put forward by CSOs), creditors must undertake sufficient duediligence to certify that a loan is being used for legitimate purposes, with the expectation that
such a loan would not later be deemed odious.
Table 2: Odious Debt Frameworks
Frameworks
Ex-ante
Ex-post
By regime
An international body would
Successor regimes argue,
be charged with declaring
through litigation, that the
regimes odious. Loans to
predecessor regime was
regimes so declared would not
odious and therefore that its
be enforceable.
debts should not be honored.
Loan-by-loan
Loans certified to comply with Disbursed loans are audited
the framework’s standards are
and borrowers sue for
enforceable, while those that
cancellation of those loans
do not may not be.
found to be odious.
Before we proceed with a systematic analysis of the impact of these different policies on the
costs identified earlier, we must consider whether any odious debt policies may create new costs.
If regimes are barred from borrowing – or costs of financing increase – due to the
implementation of an odious debt framework, at least three new costs could plausibly emerge: (i)
“odious” regimes may default on debt, previously contracted by non-odious regimes, leaving
successor governments with a large stock of arrears on debt that is according to the policy
proposal legitimate and must therefore be repaid; (ii) the consumption/investment choice of an
odious regime may be distorted against the interests of the population (Choi and Posner, 2005;
Gil Sander, 2008); and (iii) odious regimes may substitute borrowing with more intensive
exploitation of non-renewable natural resources (Choi and Posner, 2005), a topic discussed in
24
greater detail by Ochoa (2008), who concludes that “alternative sources [of financing for odious
regimes] may often result in more long-term damage to the people and the territory of a country
than debt.” (Ochoa 2008, p. 159).
1. Odious Regimes
1.1 Ex-post version
We assume that an ex-post odious regime framework would allow a government to argue in front
of an appropriate forum (e.g., the International Court of Justice or another relevant court or
arbitral tribunal entrusted with the settlement of disputes between the parties to the loan
agreement in question) that its predecessor regime was odious, and therefore that all loans made
to the regime cannot be enforced or should not trigger the usual default provision in commercial
contracts or official debt agreements.
Under the ex-post version of the odious regimes framework, the change in legal costs related to
commercial debt are ambiguous, though likely similar to the situation without the framework.
Successor governments would have to argue the case that their predecessors were odious. Given
the time required to establish the odious nature of the previous regime through litigation, the expost framework would probably not improve access to financing that would be restricted by legal
means (i.e. there may still be a shortage of short-term credits due to fear of attachment, which
may still lead to a reduction in trade). The actual costs of engaging in litigation would still have
to be undertaken. Successful litigation would allow work-out at favorable terms, although it is
difficult to estimate the magnitude of such improvement in terms. For example, Argentina
received a reduction of over 70 percent of the nominal amount of its debt from commercial
creditors without an odious debt framework in place. Nevertheless, the legal costs are likely to be
lower when compared to a loan-by-loan approach, since a decision to declare a regime odious
would presumably cover all the debts contracted by it.
If the ex-post odious regimes framework does achieve a reduction in the costs of repudiating
odious debts, the costs of borrowing for all countries are likely to increase, since creditors would
price in an expected probability of the regime being declared odious (and thus having a higher
25
probability of defaulting). This increase in borrowing costs would be higher for those
regimes/loans that are most likely to be odious; indeed, there are likely to be cases where new
lending dries up altogether due to the high risk of a repudiation. However, in many cases there
will be uncertainty about the regime type, and legitimate regimes, i.e. regimes that are never
declared odious, would suffer from higher borrowing costs.
Since the willingness of creditors to offer new loans is an important incentive for debt
repayment, if the ex-post odious regime framework succeeds in restricting access of odious
regimes to new loans, those regimes may be more likely to default on earlier (and by definition
legitimate) debt. Moreover, there may be an adverse selection effect: those creditors that are
most committed to the framework (and do not extend loans to potentially odious regimes) will be
punished with defaults on loans contracted by predecessor regimes, whereas “rogue” creditors
that lend to “odious” regimes are likely to be repaid (at least as long as the odious regime is in
power). Thus, even if the framework punishes the “rogue” creditors once the odious regime is
overthrown, the successor regime may have to deal with large amounts of arrears on legitimate
debt, often incurring substantial penalties in addition to interest on overdue principal and being
cut-off from lending till arrears are cleared.
The legal costs related to official debt under the ex-post odious regimes framework are also
ambiguous. Lending by many official creditors is related to a country’s quality of polices and
institutions and tends in any case to dry out in response to concern from civil society in donor
countries in countries with severe policy failures To the extent that the framework
institutionalizes the restriction of lending to odious regimes, there will be less “odious debt” to
be worked out. But, similarly to commercial debt, incentives for odious regimes to default on
legitimate debt would be created. Official creditors generally do not lend into arrears, and it is
unlikely that the framework, with its requirement of a litigation process to argue that a regime is
“odious,” would speed up a debt work-out relative to the existing restructuring mechanisms.
Thus, the effects of restrictions on short-term credits would likely remain unchanged from the
current situation. Since official creditors will also be unable to predict perfectly which regimes
would be deemed ex-post odious, in the long run the availability of resources could be decreased
overall given a fixed lending envelope and fixed borrowing costs.
26
Summary
The ex-post odious regimes framework is likely to reduce the welfare of countries that have
legitimate regimes, since they are likely to face higher borrowing costs due to the risk of being
declared odious ex-post. The welfare impact on countries under odious regimes is ambiguous,
but likely to be negative: legal costs are unlikely to be reduced, and any benefits from reduced
lending to odious regimes are likely to be offset by the cost of dealing with costly legitimate
arrears left by the previous odious regime.
Table 3: Ex-post Odious Regime – Summary
Creditor/Cost
Commercial
Legal
Ambiguous/similar – litigation
costs must still be incurred.
Official
Ambiguous/similar – need for
litigation and arrears on
legitimate debt will require
time for work-out.
Market
Possibly lower difference
between pre- and postrepudiation borrowing costs,
mostly due to higher predefault costs for all borrowers.
Higher –potentially more
arrears to creditors that stop
lending to previous regime.
1.2 Ex-ante framework
We consider an ex-ante odious regime framework in the vein of that suggested by Jayachandran
and Kremer (2006), whereby an appropriate institution (e.g., the UN Security Council or the
IMF) would declare a regime odious based on human rights or financial mismanagement, with
the consequence that all loans made to it from that point on would not be enforceable or that the
usual default provision in commercial or official debt contracts would not be triggered. The key
feature of the ex-ante version of the odious regime framework is that the debt of the odious
regime would be legitimate until the appropriate institution declares it odious – otherwise, the
same analysis of the ex-post version applies. As argued by Jayachandran and Kremer, this would
preserve legitimate lending by ensuring creditors that they would only be “punished” if they
knowingly lent to a regime that acts against the interest of its population, where the “knowingly”
would be precisely defined by the declaration.
27
Under the ex-ante version of the odious regimes framework, the legal costs related to repudiating
commercial debt contracted by the odious regime are likely to decline. Indirect legal costs –
such as the potential difficulty in obtaining letters of credit and other short-term trade financing –
are also likely to decline since there would be no delay in establishing the illegitimacy of
”odious” loans. However, there will be legal costs associated with the work-out of arrears on
legitimate debt, which the new regime would be expected to inherit from the predecessor odious
regime as argued earlier. Since by definition these would be arrears on legitimate debt, the terms
of the work-out are unlikely to be at more favorable terms than would be available without the
policy in place.
The market costs related to repudiating commercial debt contracted by the odious regime are
likely to decline, in part due to an increase in borrowing costs pre-default. The increase in
borrowing costs will depend on the probability that existing regimes will be declared odious, as
well as the probability that odious regimes will be replaced by non-odious regimes. An open
question is whether markets would consider repudiation in those circumstances “justifiable” and
would coordinate not to “punish” the country. As shown by Kremer and Jayachandran (2002),
this is one possible equilibrium, but there are others where restrictions to finance could emerge. 21
Since odious regimes are likely to accumulate arrears on legitimate debt (at least to some
creditors), restrictions in the availability and cost of financing for non-odious regimes is likely
proportional to the probability that regimes would be declared odious. Thus, some of the same
concerns as with the ex-post regime still arise.
Under the ex-ante version of the odious regime framework, the legal costs related to repudiating
official debt contracted by the odious regime are ambiguous. While lending to “odious” regimes
would decrease and hence, the amount of debt “odious” regimes could default on, the incentive
to default on legitimate debt would increase for these regimes. As with the ex-post framework,
odious regimes would have incentives to default on legitimate debts, leading to costs associated
21
The questions arise whether markets would perceive the successor to an odious regime that defaults on “odious”
debt as a “bad” payer and whether markets will punish successor governments because they cannot coordinate
around the declaration of odiousness (as discussed in Kremer and Jayanchandran (2002).
28
with the clearance of arrears on debt contracted by a non-odious government, which are unlikely
to be lower than existing costs for restructuring official debt.
Summary
The ex-ante odious regime policy proposal has some clear advantages over the ex-post proposal
by clearly identifying which loans are enforceable. In both cases, the benefits may be limited by
higher borrowing costs for all regimes that would result if borrowing restrictions make odious
regimes more likely to default on non-odious debt. Moreover, there are likely to exist
tremendous practical difficulties of achieving consensus within any international to identify
odious debts. The behavior of official creditors is unlikely to change drastically, since many
already in effect refuse to lend to certain regimes, and those that do generally do not expect to
enforce their claims in Western courts and may only be deterred by the inability to sell their
claims, a practice that is relatively uncommon.
Table 4: Ex-ante Odious Regime – Summary of Costs
Creditor/Cost
Commercial
Legal
Ambiguous. Lower through
drying up of lending to the
regime ex-ante, but legitimate
debt in default could receive
less favorable treatment.
Official
Decline in magnitude of
lending may be small, since
some creditors already restrict
lending to certain regimes.
Market
Ambiguous. If the market
coordinates around the declaration
of odiousness as a justifiable
default, costs could decline.
Overall costs likely to increase to
all borrowers.
Higher, because more legitimate
arrears could accumulate as fewer
creditors lend to the odious regime.
2. Odious Loans
2.1 Ex-post framework
The ex-post odious loan proposal suggest that countries should have audits of their debt
portfolios and repudiate those loans that have been deemed odious, regardless of the type of
29
regime that contracted the debt. 22 Governments would argue in front of an appropriate forum
(e.g. a court or arbitral tribunal entrusted with settling disputes between the parties) that, based
on the results of its audit, the loan is odious and the court or arbitral tribunal should therefore not
pronounce on its repayment.
Legal costs related to repudiating “odious” commercial debt under the ex-post odious loans
framework are likely to be higher than those associated with current defaults. Direct legal costs
would increase since costly and time-consuming debt audits would be required in addition to the
costly litigation required to argue that the loans are odious. Moreover, indirect legal costs are
unlikely to be changed. Given the lag to establish the odious nature of the debt in legal
proceedings, this version of the framework would probably not improve access to financing,
restricted by legal means. Finally, successful litigation will likely allow for full cancellation of
the claim, which is more than what may be obtained without the framework.
Market costs related to repudiating commercial debt under the ex-post odious loan framework
will depend on whether the probability of default would increase and/or whether the recovery
value would decrease. As noted earlier, it is possible that legal costs under this framework
increase, and therefore the probability of default would be unchanged. 23 However, since the
expected recovery in case of a default could be reduced, creditors may compensate by increasing
borrowing costs. This would also be the case if creditors incur more due-diligence expenses.
Therefore, market costs would be either similar or higher than in the situation without the
framework, and borrowing costs could increase for all countries. Although odious regimes are
likely to find it more costly to obtain loans, it is likely that the incentives for the odious regimes
to default on legitimate debt – especially from commercial creditors – will be less under the loanby-loan approach compared to the regime-by-regime one. Thus, while it is still possible that
odious regimes may have higher incentives to default on legitimate debt, this effect would likely
be less severe.
22
The audit of the Ecuadorian “Comision para la Auditoria Integral de la Deuda Publica”(CAIC), established in
2007 to investigate Ecuadorian loans contracted in the period 1976 to 2006, is an example of this ex-post loan
framework.
23
If legal costs of debt odious are higher than those related to default because of inability to pay, countries will opt
out of the framework and claim inability to pay.
30
Legal costs related to repudiating official debt under the ex-post odious loan framework would
most likely increase. Direct legal costs such as litigation would be higher than under the odious
regime case given the need for a costly and time-consuming debt audit. Given that official
creditors may also be expected to undertake additional efforts of due-diligence of new loans (as
many already do), the repudiation of any loan found ex-post to be odious would involve shortterm indirect legal costs. 24
Another source of the increase in costs is the high degree of subjectivity of certain definitions of
odious debt. As discussed in more detail by Nehru and Thomas (2008), categories such as
“ineffective” debt are often difficult to define and to identify in practical terms. It would be very
difficult to differentiate between a good ex-ante project (i.e. one with high expected returns) that
happened to fail (which would be well aligned with the interests of the population and therefore
desirable) compared to a project that failed because it was bad ex-ante. In particular, broad
definitions of odious debt would either drive up the existing due-diligence costs, or, more likely,
lead to a possible “market” effect in official lending away from risky projects, which would be a
welfare-reducing outcome (since this would imply that many projects that could turn out to
realize high returns would not be financed or would be financed at higher costs by other
creditors).
Summary
The ex-post odious loans framework creates an unambiguous increase in legal costs, and thus is
likely to be pursued primarily where the prospect of full cancellation, compared to a partial
cancellation possible under the current legal framework, compensates the higher legal costs.
24
Of course, these legal costs would not apply if a creditor would announce unilaterally the cancellation of certain
loans since in this case the borrowing country would not repudiate on its loan. Norway announced, for example, in
2006 that it would unilaterally and without conditions cancel US$80 million in Ship Export debt owed by 5
countries. The Government stated: “The [Ship Export] campaign represented a development policy failure. As a
creditor country Norway has a shared responsibility for the debts that followed. In cancelling these claims Norway
takes the responsibility for allowing these five countries to terminate their remaining repayments on these debts."
Norway also indicated that the unilateral cancellation of the ship export debt would be implemented outside the
cooperative framework of the Paris Club of creditor countries, but that this unilateral forgiveness would be a one-off
debt relief policy measure and that all future debt forgiveness would be effected through multilaterally coordinated
debt relief operations. See: http://www.regjeringen.no/nb/dep/ud/Pressesenter/pressemeldinger/2006/Cancellationof-debts-resulting-from-the-Norwegian-Ship-Export-Campaign-1976-80.html?id=272158
31
Also, borrowing costs (or the increase in costs post-repudiation) would go up due to stricter duediligence or lower expected returns. Moreover, depending on how broad the definition of
“odious loan” is, there could be a tendency for both commercial and official creditors to shy
away from riskier projects that nonetheless have high ex-ante returns and would therefore be in
the interests of the country’s population.
Table 5: Ex-post Odious Loans – Summary of Costs
Creditor/Cost
Commercial
Legal
Higher, but work-out could be
more favorable.
Official
Higher, especially if definition
of “odious” is ambiguous.
Market
Pre- and/or post-default costs higher
due to increased due-diligence or
reduced expected returns.
Lower incentives to lend into “risky”
projects that might be declared
“odious”.
2.2. Ex-ante framework
The ex-ante odious loans framework is related to the concept of “responsible lending”, since it
would require lenders to abide by certain lending standards (e.g., the Equator Principles).
However, if it would go beyond a “responsible lending” framework, since loans that do not
comply with pre-defined standard could be questioned on legitimacy grounds. On the other hand,
once a loan is judged to have met those standards, it cannot be repudiated on the basis that it is
illegitimate, including, for example, in the case where the project fails or where it is later
discovered that the money was used other purposes than originally intended.
The costs of an ex-ante odious loan framework, especially for commercial creditors, would
depend on the ex-post status of loans that do not meet the “responsible lending” standard. If
loans that do not meet the standard are regarded as legitimate and enforceable, governments and
creditors would be able to effectively opt out of the framework. The second possibility would be
for a loan that does not meet the standard to be unenforceable (i.e. it is by default assumed to be
illegitimate). A third possibility – that loans that are not covered could be litigated as to their
legitimacy – is equivalent to the ex-post approach since the key difference between ex-ante and
32
ex-post frameworks lies in the parties’ knowledge of the legal implications of repudiation in the
former, but not in the latter framework.
In the first scenario (where loans are by default enforceable), one might expect that most
countries and creditors would wish to avoid the high costs of due-diligence beyond that which is
legally required to guarantee enforcement (i.e. comparable to what exists at present) and would
opt out of the framework, in which case costs would not be affected. On the other hand,
commercial creditors may welcome such a framework as it helps their reputation for corporate
social responsibility. Moreover, if the loans could be questioned ex-post, participating in the
framework would likely improve the likelihood of enforcement. We consider below the
implications of a stronger version of the current system – namely declaring all non-compliant
loans to be, in principle, illegitimate.
The effect of this framework on the litigation costs (such as lawyers’ fees) related to commercial
debt is unclear. On the one hand, there would be more elevated costs to certify that loans meet
the framework’s criteria. On the other hand, ex-ante frameworks generally reduce the need for
legal proceedings since they preclude arguments of illegitimacy if the government were to try to
repudiate a loan that was certified to meet the standards of the framework or if creditors tried to
recover on a loan that was not certified as meeting the appropriate standards.
Market costs of repudiating loans not meeting the standards of the framework are likely to be
lower, as creditors that adopt the framework are unlikely to coordinate with a non-participant in
punishment lest they provide incentives for free-riding by those creditors. Costs of pre-default
financing would increase, however, for all countries, proportionally to the increased cost related
to adopting the policy. Note that such an increase is not seen in interest rates charged, but it is
customary for commercial creditors to deduct loan preparation costs – including due-diligence
costs – from the proceeds, thus increasing the “all-in” cost of the loan.
Compared to the other policies, the incentive for regimes to default on legitimate debt is
probably the lowest because even “odious” regimes retain access to finance for certain projects,
33
but are probably still higher than under the current situation without any odious debt policy
because the cost of verifying the legitimacy of loans to certain regimes will be prohibitively high.
By avoiding all ex-post legal proceedings and building on existing due-diligence practices, the
ex-ante odious loans framework would likely reduce overall legal costs of restructuring debt to
official creditors, however, borrowing costs of these creditors would increase. And similarly, to
the ex-post loan approach, official creditors may shun away from projects where the costs of
meeting the proposed standards would be very high, even if these projects might be in the
interest of the population.
Summary
The ex-ante odious loans framework (with the assumptions that loans not meeting the
framework’s standards are not enforceable) presents some attractive features relative to the other
proposals – most notably, it does appear to actually reduce ex-post legal costs without a
substantial increase on market costs for both commercial and official lenders. However, these
benefits are not without their costs: increased due-diligence requirements would increase overall
borrowing costs, which will largely be borne by all borrowers, including those with adequate
control systems. Moreover, costs would especially increase for high-risk projects, which may not
be desirable if those projects also have low returns.
Most importantly, designing such a framework would be challenging, especially since most
benefits hinge on very well-defined ex-post expectations. Current governments, especially of
market-access countries, and their creditors are unlikely to favor a system that would force all
loans to require costly due-diligence expenses, especially if the requirements are broad.
34
Table 6: Ex-ante Odious Loan – Summary of Costs
Creditor/Cost
Commercial
Official
Legal
Higher ex-ante, lower ex-post
if legal status of noncomplying loans is clear.
Ex-ante costs may increase, for
example as a result of
increased legal costs for
certifying the compliance of
projects with the framework;
similar or lower ex-post costs if
legal status is clear.
35
Market
Higher due to due-diligence,
but lower costs to repudiate on
non-complying loans.
As above, assuming duediligence costs and default
rates generally similar.
IV.
CONCLUSION
Although the objective of ensuring that governments use the proceeds from external loans for the
benefit of their population is a laudable one, “odious debt” frameworks are unlikely to offer a
costless solution. The policies proposed by CSOs (with the possible exception of the ex-ante loan
policy) do little to unambiguously reduce the costs of defaulting on loans deemed to be
illegitimate – and therefore to dissuade lending for illegitimate purposes. Frameworks based on
regime type definitions pose tremendous challenges for the body or bodies charged with
adjudicating on the type of regime, and in addition generate incentives for despots to default,
especially to those creditors most committed to the goals of the framework. Frameworks based
on individual loans entail high direct legal costs – whether of auditing loan portfolios and
litigating or certifying that each loan complies with the framework’s standards. Ex-ante
frameworks appear superior to ex-post ones as they minimize the impact on non-odious
governments, although they do not remove all uncertainty: many countries will be penalized for
the probability of being declared odious even if they never turn out to be, and worthwhile but
risky projects may not be undertaken.
The “ex-ante odious loans” policy seems to be the least distortionary. Although it entails high exante costs, if well-designed it could improve the use of loan proceeds while minimizing other
effects. However, it would still lead to a substantial increase in borrowing cost. And most
importantly, even a well-designed ex-ante odious loans policy does not avoid the problem with
the fungibility of resources: if odious regimes cannot borrow to buy weapons or line their
“private” bank accounts, they may use domestic revenues or exploit natural resources more
intensively. Any loan-by-loan approach is only effective in ensuring that loan proceeds are used
in the interest of populations living in countries where a large volume of financial flows is
external loans, which is not the case in most countries, but particularly applies to low-income
countries. As a consequence, the proposed odious debt policies are most likely to increase the
borrowing costs in those countries that require access to relative cheap external loans in order to
finance their development needs.
36
Perhaps more importantly, a loan-by-loan approach – or indeed any framework that focuses
exclusively on debt – would not address the important issues of improving public financial
management and building and using domestic budget monitoring systems – i.e. to build the
capacity for the country’s own population and civil society to monitor the expenditure of all
resources administered by the state – not only those that arise from external borrowing. In sum,
our analysis suggests that the economic costs of “odious” debt policies are non-trivial and they
should be carefully considered by governments and organizations involved in this debate.
37
V. REFERENCES
Alexander, Lewis S., 1987. The Legal Consequences of Sovereign Default, Federal Reserve
Board, Mimeo Washington D.C.
Álfaro, Laura, Noel. Maurer, and Faisel. Ahmed, 2007. Gunboats and Vultures: Market Reaction
to the ‘Enforcement’ of Sovereign Debt. Working Paper, Harvard Business School, Boston, MA,.
Akerlof, George., Mani Maun 1970: The Market for Lemons: Quality Uncertainty and the
Market Mechanism. Quarterly Journal of Economics 84 (3): 488–500
Bolton Patrick. & Jeanne, Olivier., 2007. Structuring and Restructuring Sovereign Debt: The
Role of a Bankruptcy Regime, IMF Working Papers 07/192
Bolton, P. and J, Skeel,., 2007 Odious Debts or Odious Regimes?. U of Penn, Inst for Law &
Econ Research Paper No. 07-30
Borensztein, Eduardo. and Ugo. Panizza 2006. The Cost of Default. Washington, DC: InterAmerican Development Bank. Mimeo.
Borensztein, Eduardo. and Ugo. Panizza 2006. Do sovereign defaults hurt exporters? RES
Working Papers 1018, Inter-American Development Bank, Research Department.
Bulow, Jeremy. and Kenneth. Rogoff, 1989. A Constant Recontracting Model of Sovereign Debt.
Journal of Political Economy 96, 155-178
Chowdhry Bhagwan., 1991 What is different about international lending?. Review of Financial
Studies 4, pp. 121–148.
Cline, William R. 1987 Mobilizing Bank Lending to Debtor Countries, Institute for
International Economics, Washington D.C.
De Paoli, B.S and V. Saporta 2006, Output costs of sovereign defaults: some empirical estimates,
Bank of England Working Paper, forthcoming.
.Eaton Jonathan and Mark. Gersovitz, 1981 Debt with potential repudiation: Theoretical and
empirical analysis. Review of Economic Studies 48 (1981).
Eichengreen, Barry., 1987. "Till Debt Do Us Part: The US Capital Market and Foreign Lending,
1920-1955," CEPR Discussion Papers 212, C.E.P.R. Discussion Papers
English, William B., 1996. Understanding the costs of sovereign default: American state debts in
the 1840s. American Economic Review 86, pp. 289–309
Flandreau Marc. and Frederic. Zumer 2004 The Making of Global Finance, 1880-1913.
Paris OECD
38
Gelos, R.Gaston, Sahay Ratna and Guido.Sandleris, 2004Sovereign Borrowing by Developing
Countries: What Determines Market Access? . IMF Working Paper No. 04/221
Gil Sander, Frederico, 2008. "Odious Debt" as a Principal-Agent Problem, mimeo, World Bank,
Washington, D.C.
Grossman, Herschel. I. and , John.B.,Van Huyck. 1989. Sovereign Debt as a Contingent Claim:
Excusable Default, Repudiation, and Reputation . National Bureau Economic Research Working
Paper No.W1673.
“International Development Association and International Monetary Fund 2008, “The Heavily
Indebted Poor Countries (HIPC) Initiative and Multilateral Debt Relief Initiative (MDRI) Status of Implementation Report. Washingon, DC.
Jayachandran, Seema. & Michael. Kremer, 2006. Odious Debt. American Economic Review,
American Economic Association, vol. 96(1), pages 82-92, March.
Kletzer Kenneth.M., and Brian.D., Wright. 2000. Sovereign debt as intertemporal barter,
American Economic Review 90 pp. 621–639.
Kremer, Michael and Seema. Jayachandran 2002. Odious Debt. National Bureau of Economic
Research Working Paper No. 8953
Laeven, Luc and Fabian Valencia 2008 Systemic Banking Crises: A New Update. IMF Working
Paper WP/08/224.
Lane, Philip. 2004. Empirical Perspectives on Long-Term External Debt. Issues in
Macroeconomics. 4:1-21
Levy, Yeyati, and Ugo. Panizza. 2006 The Elusive Costs of Sovereign Defaults . CIF Working
Paper No. 11/2006
Lewis, Alexander. 1987. The Legal Consequences of Sovereign Default.. Mimeo, Federal
Reserve Board, Washington D.C.,
Lindert Peter. and Peter Morton, 1988 How Sovereign Debt Has Worked, in Jeffrey D.
Sachs (ed.) Developing Country Debt and the World Economy (University of Chicago
Press for the National Bureau of Economic Research, pp. 225-235.
Martinez, Jose Vicente and Guido Sandleris, 2006. Is it punishment? Sovereign defaults and the
decline in trade. Unpublished Paper, Columbia University, New York, NY.
Mitchener, Kris and Marc Weidenmier, 2005.., Supersanctions and Sovereign Debt Repayment
National Bureau Economic Research Working Paper No.W11472, Cambridge, MA.
39
Nehru Vikram. and Mark Thomas. (2008). The Concept of Odious Debt: Some Considerations.
Economic Policy and Debt Department Discussion Paper, The World Bank, Washington, D.C.
Ochoa Christiana, 2008 From Odious Debt to Odious Finance: Avoiding the Externalities of a
Functional Odious Debt Doctrine, Harvard Journal of International Law, vol. 49 no.109, .
Ozler, Sule, 1993 Have Commercial Banks Ignored History?, American Economic Review, Vol.
83. No.3, pp. 608-620.
Rogoff, Kenneth S. and Jeromine Zettelmeyer, 2002.. Bankruptcy Procedures for Sovereigns: A
History of Ideas, 1976-2001 IMF Working Paper
Rose, Andrew. 2005. One reason countries pay their debts: renegotiation and international
trade, Journal of Development Economics, Elsevier, vol. 77(1), pages 189-206, June.
Rose Andrew. K &. Mark Spiegel, 2002. A gravity model of sovereign lending: trade, default
and credit, Working Papers in Applied Economic Theory 2002-09, Federal Reserve Bank of San
Francisco.
Sack, Alexander N., 1927. Les Effets des Transformations des États sur leurs dettes publìque et
autres obligations financières.
Sturzenegger, Federico., 2002, Default Episodes in the 90s: Factbook and Preliminary Lessons,
Manuscript, Universidad Torcuato Di Tella.
Sturzenegger, Federico. and Jeromin Zettelmeyer 2007. Debt Defaults and Lessons from a
Decade of Crisis. Cambridge: MIT Press.
Tomz, Michael. 2007. Reputation and International Cooperation: Sovereign Debt Across Three
Centuries. Princeton NJ: Princeton Univ. Press.
Waibel, Michael.W. 2003. Sovereign Debt Restructuring, mimeo.
40